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Big Changes Bring Big Forecast Shifts: Four Scenarios

Dr. Daniel Bachman

It is rare for economic forecasters to change outlooks substantially over the course of a few months. Most economic news tells us only a little about how things are changing—one release is positive, the next negative, and the net difference is not all that large. But this time really is different.

The election of Donald Trump as president qualifies as a very significant change to the economic outlook. There is no simple template for the policy mix to be expected from his new administration. Presidential candidates generally don’t present policy proposals that are terribly detailed, and president-elect Trump’s proposals tended to be less fleshed out than usual

In the long transition period, this mainly takes the form of uncertainty. And U.S. economic policy isn’t determined by the president waving a magic wand. It requires buy-in from Congress, and Trump’s relationship with Congress is itself difficult to predict. Future policy outcomes range widely as a result.

Our baseline reflects a relatively successful implementation of Trump’s key economic proposals, although at more modest levels. These include:

1. A temporary infrastructure spending program of about $250 billion: Spending starts in early 2018, ramps up through 2019, then falls off as the program ends in 2020 and 2021.
2. Permanent business and personal tax cuts with a static impact of $300 million in the five years of our forecast.
3. Suppression of international trade: Imports are forecast to grow more slowly than history would suggest based on GDP, reflecting some combination of tariffs and increased barriers to trade. Exports also grow more slowly, reflecting barriers and tariffs in other countries.
4. Higher costs due to supply chain interruptions from the trade barriers, and because of higher labor costs as undocumented immigrants leave the labor force.

The baseline also includes two key assumptions about expectations in the short run:

1. Lower investment spending in early 2017, reflecting both increased uncertainty and higher interest rates.
2. Higher interest rates starting in early 2017, reflecting expectations that the new economic policies will lead to higher deficits and a full-employment economy, both of which suggest that future interest rates will rise.

Dr. Rumki Majumdar

We do not judge that the supply-side elements of the program, such as regulatory relief, will have a large impact in the five-year forecast horizon. This doesn’t mean that they might not be important for the economy’s long-run growth. But over the next few years, the impact on economic aggregates (such as GDP, employment, and inflation) will be dominated by the large demand-side impacts of this policy mix.

All economic forecasts include assumptions about policy. But this forecast’s accuracy will be particularly sensitive to the policy choices and accomplishments of the new administration. Each of the main macroeconomic policy interventions—the infrastructure spending plan, the tax cuts, and raising the trade barriers—can be carried out in larger or smaller measures. The resulting policy mix will almost certainly differ from the assumptions here. How it will be different is a big question.

The result of our assumption is a few quarters of slow growth starting in 2017 because of the unusual level of uncertainty (particularly around international supply chains). By early 2018, that uncertainty may give way to faster growth because of the demand- side impact of tax cuts and infrastructure spending. By 2020, the infrastructure program likely begins to wind down, reducing GDP growth.

With the economy now relatively close to full employment in the model, the demand stimulus creates inflationary pressures. That’s made worse by the trade barriers, which may raise prices for consumer goods as well as increase the cost of doing business. This can lead to much faster Fed movement and much higher long-term interest rates in the baseline simulation than in our previous forecast.*

Scenarios

Our scenarios are designed to demonstrate the different paths down which the new administration’s policies might take the U.S. economy. Foreign risks have not dissipated, and we’ve incorporated them into the scenarios. But for now, we view the greatest uncertainty in the U.S. economy to be that generated within the United States.

─The baseline (55% probability): Uncertainty restrains business investment in early 2017, but tax cuts and infrastructure spending push up GDP in 2018 and 2019. With the economy at full employment, the faster GDP growth creates some inflationary pressures. Increased trade restrictions add to the price pressures. The Fed moves aggressively to prevent inflation from picking up too much, and long-term interest rates rise substantially. Growth rises to 2.5% to 3.0% for a couple of years before falling off as the impact of the stimulus fades.

─Recession (5%): Sudden policy changes in the United States, including a large tariff on Chinese goods, trigger a global financial crisis. The crisis is exacerbated by the sudden change in global supply chain cost structures from higher US trade barriers, as well as retaliation from China. The Fed and the European Central Bank act to ease financial conditions, and growth starts to pick up as businesses adopt to the new global costs and restructure their capital to reflect the new global cost structure. GDP falls in the last two quarters of 2017 and recovers after 2018.

─Slower growth (30%): The infrastructure program and tax cuts stall in Congress. And the administration has placed significant restrictions on US imports, raising costs and disrupting supply chains. Businesses hold back on investments to restructure their supply chains because of uncertainty about future policy. Global growth also slows because of the supply chain disruptions, reducing demand for U.S. exports. GDP growth falls to 1% over the forecast period, and the unemployment rate rises.

─Successful policy takeoff (10%): The administration takes only symbolic action on trade. With supply chain disruptions off the table, businesses focus on tax cuts that are designed to in-crease investment spending, and the opportunities available from the infrastructure plan. Tightening labor markets attract many people back into the labor force, and the high labor-force participation rate helps to moderate the impact of faster growth on wages and inflation. Growth remains above 2% for the next five years.

For sure, the unexpected results of the presidential election have introduced uncertainty into both the U.S. economy and our forecast. We may see policy shifts in trade, infrastructure spending, taxes and regulation—with a range of possible impacts for business and consumers. For details on specific sectors and topics, including consumers, housing, business investment, foreign trade, government, labor markets, financial markets and prices, see the full article.

─Excerpted from “United States Economic Forecast, 4th Quarter 2016,” by Dr. Daniel Bachman, senior manager for U.S. macroeconomics at Deloitte Services LP, and Dr. Rumki Majumdar, macroeconomist and a manager at Deloitte Research, Deloitte Services LP, published in Deloitte University Press.

Endnote

1. Unless otherwise noted, all data supplied by Haver Analytics, which compiles statistics from the US Bureau of Labor Statistics, the Bureau of Economic Analysis, and other databases. See www.haver.com/databaseprofiles.

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